Ohio Supreme Court Declines to Adopt Blanket “At the Well” Rule

The question of whether Ohio follows the "at the well" rule or the "marketable product" rule will have to wait for another day. And that might not be a bad thing for Ohio landowners. After months of anticipation, the Ohio Supreme Court finally issued an opinion in the closely watched Lutz v. Chesapeake Appalachia, LLC matter. The opinion, however, punted on the central question of whether gas royalties are to be valued at the wellhead or at the location where the gas is deemed marketable. Instead, the Ohio Supreme Court correctly ruled that the express language in the parties’ oil/gas lease determines the royalty valuation point. Although drillers and landowners alike were initially disappointed by the Ohio Supreme Court’s "non-decision", the author believes that the rationale espoused by the Lutz court is the right approach and should be adopted by Pennsylvania.

The Lutz litigation originated in federal court in 2009. At issue were two oil/gas leases which were executed in the early 1970s. The landowners, Regis and Marion Lutz, argued that because there is no market for the gas at the well itself, the lessee, Chesapeake, has an implied duty to market the gas once it is brought to the surface. Given this implied duty, the landowners further argued that Chesapeake must bear all of the costs incurred between the wellhead and the eventual point-of-sale. In essence, the landowners urged the Ohio Supreme Court to adopt the "marketable product" rule and hold that no costs can be deducted unless and until the raw gas is transformed into a marketable condition.

Chesapeake, on the other hand, argued that Ohio should follow the "at the well" rule and give effect to the language set forth in the parties’ lease. The royalty clauses in each lease provided that the royalties were to be paid based on "the market value at the well". Since the gas was sold downstream from the wellhead, Chesapeake used the netback method to deduct the costs incurred between the wellhead and the eventual sale location. Chesapeake argued that Ohio follows the "at the well" rule, which permits the use of the netback method to calculate the market value of the gas at the wellhead. Contrary to the landowner’s suggestion, Chesapeake urged the Ohio Supreme Court to reject the "marketable product" rule and confirm that Ohio is, in fact, an "at the well" jurisdiction.

The Lutz matter took a rather uncommon path to the Ohio Supreme Court. As noted, the litigation was originally commenced in the United States District Court for the Northern District of Ohio sitting in Akron (the "Federal Suit"). In August 2014, Chesapeake moved for summary judgment in the Federal Suit. Chesapeake requested that the landowner’s contract claim be dismissed since the deductions were taken in accordance with the netback methodology. The landowners filed their own motion for summary judgment seeking an order that Chesapeake had breached the leases by taking improper and unauthorized deductions. The judge in the Federal Suit was unable to decide the cross-motions because of the murky status of Ohio law on deductions. As such, in March 2015, the judge requested clarification from the Ohio Supreme Court on this certified question of Ohio law:

Does Ohio follow the "at the well" rule (which permits the deduction of post-production costs) or does it follow some version of the "marketable product" rule (which limits the deduction of post-production costs under certain circumstances)?

A certified question is a formal request by one court to another for a clarification of state law. See, Rule 9.01 of the Ohio Supreme Court’s Rules of Practice ("[t]he Supreme Court may answer a question of law certified to it by a court of the United States"). On April 6, 2015, the Ohio Supreme Court accepted the request and agreed to "answer" the certified question.

In a rather surprising and unexpected opinion, the Ohio Supreme Court declined to answer the certified question as posed. Instead, the Lutz court opined that the precise language in the underlying lease controls and that the deduction analysis must essentially begin and end there:

"[U]nder Ohio law, an oil and gas lease is a contract that is subject to the traditional rules of contract construction. Because the rights and remedies of the parties are controlled by the specific language of their lease agreement, we decline to answer the certified question…"

The Court noted that, like other contracts, oil and gas leases are to be interpreted so as to carry out the intent of the parties. If the lease is unclear or ambiguous, the Lutz court observed that a reviewing court may resort to extrinsic evidence to ascertain the parties’ intent. In the instant matter, the Court did not reach the question of whether the royalty clauses were ambiguous. This was a question for the judge in the Federal Suit since there was no record or other testimony before the Lutz panel on this threshold issue. Conversely, the Lutz panel noted that if the royalty clauses were unambiguous, the judge in the Federal Suit "should be able to interpret the leases without our assistance." In short, the Ohio Supreme Court declined to adopt a sweeping "one-size-fits-all" rule of law and instead correctly framed the issue as one of contract interpretation.

For now, questions concerning the deduction of post-production costs in Ohio will be decided on a lease-by-lease basis. The message from the Ohio Supreme Court is clear: the intent of the parties, as evidenced by the language set forth in the underlying lease, will determine the royalty valuation point. If the royalty clause is unclear or ambiguous, the Lutz court also suggested that it may be proper to introduce extrinsic evidence to ascertain the intent of the parties. This means that oral testimony concerning what was discussed or not discussed during the lease negotiations may be admissible as critical evidence. This may benefit landowners who were told during the negotiations that "no deductions" will be taken or that only the cost of transporting the gas will be deducted. Likewise, the Lutz opinion suggests that lease clauses which provide that the royalty shall be calculated on the "proceeds received by the lessee" or on the "price paid to the lessee" should be interpreted and applied exactly as written. Arguably, the intent of such clauses is to value the royalty at the point-of-sale. The Lutz opinion will restore the import of such language and remove the fiction of the netback method. In any event, Pennsylvania would be wise to revisit the deduction issue and adopt the approach recently articulated by the Ohio Supreme Court in Lutz.